Cover Story: Will Credit Cards Be Next?

Not content with restrictions on debit card interchange, merchants are now targeting bigger game. A set of major antitrust cases could be just the opening salvo—and a trial is set to start in September.

By Linda Punch

While the card networks and banks are still wrestling with the repercussions from the Durbin Amendment’s restrictions on debit card interchange rates, yet another threat looms on the horizon—one that could hold even more dire consequences for the industry.

A handful of antitrust lawsuits filed by merchants six years ago challenging credit card interchange and network policies are set to go to trial in September in U.S. District Court in Brooklyn, N.Y. A favorable decision for the merchants could cost the networks and banks billions of dollars in damages, and undermine the networks’ control over merchant-acceptance practices.

In the antitrust suits—originally filed in 2005 and now collectively known as “MDL 1720”—merchants are seeking class-action status. While a trial has been scheduled to start Sept. 10, there had not been a ruling on the class-action request as of early January. And both sides are continuing court-mandated settlement talks that could bring an earlier conclusion to the case.

The lawsuits—which consist of three major complaints under the supervision of U.S. District Judge John Gleeson—name Visa Inc., MasterCard Inc., and some of their major customer and former owner banks as defendants. In the suits, citing the Sherman and Clayton antitrust acts as well as state laws, merchants depict the U.S. credit and debit card interchange process as a price-fixing scheme operated by the bank card networks and card issuers to the detriment of merchants.

Networks set interchange fees, which are paid to card issuers by merchant acquirers. The acquirers then pass the expense on to merchants. Interchange accounts for about three-fourths of the cost of accepting a Visa or MasterCard payment. Interchange was originally meant to compensate issuers for funding costs, credit risk, and other expenses, but it has generated controversy from its inception more than 35 years ago.

The merchants also are challenging the legality of certain network rules that prohibit them from surcharging for card transactions or limit their steering of customers to the merchants’ preferred form of payment. In addition, the merchants allege that the initial public offerings by MasterCard (in 2006) and Visa (in 2008), both of which were founded and developed by banks, did little to change the anti-competitive nature of the interchange system and the network policies even though banks no longer own the networks.

Permanent Cuts

The litigation began as approximately 55 lawsuits filed in various jurisdictions, with all but 10 of them seeking class-action status, according to Visa’s fiscal 2010 annual report. Plaintiffs range from local and regional retailers to national trade associations and chains such as Kroger, Supervalu, Walgreen, CVS, and others. Federal court administrators consolidated the suits in Gleeson’s court.

If Gleeson’s name sounds familiar, it should. He oversaw an earlier landmark lawsuit commonly known as the Wal-Mart case that in 2003 resulted in the end of the networks’ so-called honor-all-cards rules. Those rules forced merchants to accept Visa- or MasterCard-branded signature debit cards if they accepted the networks’ credit cards.

Having heard arguments on the matter in November 2009, Judge Gleeson is taking his time deciding on the crucial question of class status. The proposed class is huge: all U.S. merchants that have accepted Visa and MasterCard cards since 2004. That’s approximately 5 million businesses based on the 8 million locations that currently accept bank cards.

For the networks, losing a class-action lawsuit could be catastrophic. In its third-quarter 2011 earnings report, MasterCard in November estimated its potential cost to settle claims from merchants suing individually at $500 million. But it said that estimate “does not reflect the class plaintiffs’ settlement demands, which remain unacceptable given the cash component is significantly higher than MasterCard’s estimate of a reasonably possible loss and the terms include unacceptable changes to MasterCard’s business practices.”

MasterCard also said the estimate doesn’t represent its potential loss “should it lose if the merchants’ complaints go to trials.” Some observers estimate the networks and banks could owe billions of dollars in damages should they be found liable for the alleged counts, which are subject to trebling under antitrust law.

Visa has not commented on estimated potential settlement expenses, but in the company’s financial report for its fourth fiscal 2011 quarter ended Sept. 30 it lists $2.93 billion in restricted cash held in escrow for litigation.

Deutsche Bank analyst Bryan Keane in a November 2011 report estimated that damages from a class-action suit could total a “couple of hundred billion dollars.” Under a judgment-sharing and settlement agreement between Visa, MasterCard, and banks named in the suit, MasterCard and its customer banks would be responsible for 33.3% of that amount and Visa and its banks for 66.7%, Keane said.

But monetary damages are only part of the story. Merchants are demanding changes in business terms that could potentially include cuts to credit card interchange fees and recognition by the networks of merchants’ right to surcharge, Keane said in a followup report. Those changes could damage the networks’ business models, he said.

Merchants aren’t likely to agree to temporary cuts in interchange, but would instead push for permanent reductions, potentially in line with the average Australian and European interchange fees of 0.5%, Keane said. He noted that in the Wal-Mart case, the networks increased credit interchange to offset the decline in debit interchange ordered by the judge, increasing overall transaction costs to merchants.

More Flexibility

In the Wal-Mart case, merchants settled on $2 billion from Visa, $1 billion from MasterCard, a five-month reduction in debit interchange, and an unbundling of credit from debit. “The merchants said this was going to be sufficient to cause interchange to come down,” says Eric Grover, principal at Intrepid Ventures, Carson Valley, Nev.

However, the result was that PIN-debit fees rose more than 200% over the past decade. That means this time around, merchants are “going to want something with teeth around interchange,” Grover says. “And the networks and banks are going to be the most reluctant to make any meaningful concessions. Could they come up with some sort of token concession? Yeah. Are they going to want to give up anything that will cede the ability to manage interchange? I don’t think so.”

The parties directly involved in the lawsuits decline to comment on the settlement talks. But observers speculate that non-monetary issues may be the major obstacle to an agreement. While the networks and banks might be willing “to pony up a lot of money,” they’re not likely to cede control of acceptance policies to the merchants, Grover says.

“The sticking point is around interchange, around the rules governing surcharging,” he says. “It’s probably not around monetary damages.”

Indeed, the non-monetary aspects of card acceptance are among the major issues merchants have the most concerns about, says Mallory Duncan, senior vice president and general counsel at the National Retail Federation. While the NRF is not involved in the lawsuits, one issue “that merchants have complained about is the extraordinarily restrictive rules that we have to operate under,” he says. “My understanding is that the case has been focusing on those rules.”

Duncan speculates that the merchants in the antitrust cases want to build on the gains won in the Department of Justice’s recent antitrust action against Visa and MasterCard. In a settlement with the DoJ in October 2010, MasterCard and Visa agreed to allow something they had held out against for decades: some degrees of freedom for merchants to steer customers to cards that cost the merchants less to accept.

Under the agreement, the networks now allow merchants to offer customers an immediate discount or rebate or a free or discounted product or service for using a particular credit card network, low-cost card within a network, or other form of payment.

The agreement also said merchants could express a preference for and promote the use of a particular credit card network, low-cost card within a network, or other payment.

“I can’t tell you which ones they’re focusing on, but certainly the rules that interfere with merchants’ flexibility in establishing the terms of card acceptance would be one,” Duncan says. “For example, many times merchants would like to test new programs. The card companies have taken the position that you’re not allowed to test. Whatever you do at one store, you must do at every store.”

That’s unreasonable restraint because banks are allowed to test new pricing strategies and new methodologies for card programs at different banks, Duncan says. “Why should they put more restrictions on retailers than they put on themselves?” he asks.

‘A Pretty Good Argument’

That’s not to say that the two sides couldn’t find common ground and reach a settlement, Grover says. “Could there be something if the networks said, ‘Well, on average, we’ll bring our credit interchange down by 20% but we still want the ability to manage it?’” he says. “Would something like that shock me? No.”

But if the networks are forced to operate without interchange, “it’s a weaker value proposition for banks and it would be a weaker value proposition for consumers,” Grover says. He notes that 90% of the credit cards in the U.S. carry no fees, and almost all cards have some sort of tangible reward, such as cash back.

“If interchange were to fall dramatically, clearly fees on cards would go up and rewards would go down or go away,” he says. “And also, if interchange were to come down appreciably, the networks’ fees to their issuers become more visible.”

Despite the difficulties of reaching an agreement over interchange and other issues, both sides might prefer a settlement rather than subject the case to the vagaries of a jury trial, Grover says.

“Nobody wants to go to trial,” he says. “The economics of payment network interchange are difficult and people that live in the industry and study it, argue about it. If you put this in front of a jury of 12 folks from Brooklyn—a plumber, an accountant, whatever—who knows what they’re going to think?”

But even reaching an agreement on an average interchange rate could be problematic, Grover says.

“We have a couple of commercial companies out there that are competing,” he says. “They could say we’ll lower interchange by 20% or 25%, they could say we’ll base it on the following criteria subject to some sort of review panel. But I really don’t think they want to give up the freedom to manage it.”

The networks might be able to fend off some changes, such as their ban against merchants surcharging for credit card transactions, by citing their 2010 agreement with the U.S. Department of Justice, Grover says.

“The networks will say, reasonably, ‘Look, the DoJ came after us and we settled,’” he says. “’We gave them everything they wanted and we agreed [merchants] can steer, you can have preferential networks, you can discriminate between premium cards and non-premium cards, but surcharging was not part of that settlement.’ That’s a pretty good argument.”

‘Loose Ends’

Meanwhile, although the greatest threat to the networks’ interchange system lies in the antitrust suits, merchants are pushing for more regulation in other arenas as well. While no one expects Congress to take act on interchange before the 2012 election, merchants continue to lobby for action that goes well beyond the Durbin Amendment to 2010’s Dodd-Frank Act.

“We’ve always viewed debit card reform as phase one of the longer campaign to reform the entire electronic-payments market,” says Brian Dodge, spokesman for the Retail Industry Leader’s Association. “We support any effort, whether it’s legislative, regulatory, or legal, that brings fairness, transparency, and competition to the electronic-payments market.”

Among RILA’s goals for 2012 is ‘to pursue credit card reform—if not pass it, set the stage for passage in the near future,” he says. “We still find the rules that the networks force merchants to abide by are largely anti-competitive. The requirement that merchants accept all cards, regardless of the costs, an inability to steer customers effectively between payment options—these are issues that remain a struggle for retailers.”

Other evidence that merchants aren’t content with their Durbin gains can be seen in a lawsuit filed in November against the Federal Reserve Board. In that suit, three retail trade groups and two merchants accuse the Fed of failing to follow the law when it set its debit card interchange price controls and related regulations that implement the Durbin Amendment.

The suit, filed in U.S. District Court in Washington, D.C., asks the court for a declaratory judgment that would force the Fed to reconsider its rulemaking. It charges that parts of the Fed’s final rule are “arbitrary, capricious, an abuse of discretion and otherwise not in accordance with the law.”

The plaintiffs are the NRF; the Food Marketing Institute representing 40,000 grocery stores and drugstores; NACS, formerly the National Association of Convenience Stores; Boscov’s Department Stores LLC; and Miller Oil Co., a convenience store/gas-station chain based in Norfolk, Va.

The Durbin Amendment ordered the Fed to set “reasonable and proportional” debit card interchange price controls for issuers with more than $10 billion in assets. The Fed in June issued final regulations setting a price cap of 21 cents plus 0.05%, with another penny pending for fraud control. That represented a 47% fee cut on the average debit sale.

The law called for the Fed to consider only what the plaintiffs call a “bucket” of incremental costs for authorization, clearing, and settlement and forbade it from factoring in another bucket of costs not specific to a transaction, according to the NRF. The Fed had determined the actual cost for authorization, clearing, and settlement was 4 cents per transaction.

Instead, the plaintiffs say, the Fed essentially created, at bankers’ request, a third bucket of costs not covered by the statute, including network switch fees, fraud losses represented by the 0.05% ad valorem charge versus the permitted fraud-control expenses, and some fixed hardware and software costs.

The retailers also say the Fed’s rule fails to implement the amendment’s ban on network exclusivity, in which merchants’ transaction-routing choices are limited only to affiliated networks.

The Fed said an issuer could satisfy the requirement by offering a card with one unaffiliated signature and one unaffiliated PIN-debit network. But the retailers say that plan circumvents the exclusivity ban because with neither Visa nor MasterCard allowing the other’s brand for signature, the law’s requirement that merchants have an unaffiliated choice for each transaction may not be realized.

“We’re trying to clean up the loose ends from the debit card legislation,” the NRF’s Duncan says, adding that “if we can have a good solid model on the debit side and introduce transparency and competition on the credit card side, that would be a reasonable goal for us.”

Years of Wrangling

Some industry observers monitoring the interchange battle also are keeping an eye on the Consumer Financial Protection Bureau, another product of the Dodd-Frank Act. The bureau is charged with rulemaking and enforcement of consumer financial protection laws and restricting unfair, deceptive, and abusive practices.

The bureau had been leaderless until January, when President Barack Obama appointed Richard Cordray, a former Ohio attorney general, as director.

While the agency is supposed to focus on regulating consumer financial products and the networks don’t serve consumers directly, Grover says he “would worry a little bit” about what actions the bureau might take down the road.

“Networks and interchange would be fairly low on the totem pole but what would be [the CFPB’s] argument?” he says. “The argument would be that consumers are paying higher prices at retail because of interchange.”

While it’s “a stretch” to characterize credit card interchange as a consumer financial product, the agency is going to be staffed “with lots and lots of very smart people with the authority to do almost whatever they want,” Grover says. “And there’s an underlying view—notwithstanding some very benign, pleasant pronouncements that [the agency] put out—that the financial-services industry is untrustworthy and rapacious and consumers can’t fully look out for themselves.”

It’s unlikely that the bureau would take any action against the networks in the near term, Grover says. But with practices at the point of sale such as surcharging and discounting, “you can make an argument there’s a lot of stuff that is going to attract their attention sooner.”

Whatever lies ahead in the interchange battle, it’s clear that the antitrust lawsuits pose the next big challenge for the networks and banks. And among the most troubling aspects of these cases is the uncertainty swirling around just when they will be resolved.

If Gleeson grants the class-action request, the networks could be under increased pressure to settle prior to the trial because the potential verdict could reach billions of dollars, observers say. However, the networks also might appeal the class-action certification, further delaying a trial and potential settlement.

But after years of legal wrangling and settlement talks, all involved are pushing toward a conclusion of the cases. Says K. Craig Wildfang, lead attorney for the class plaintiffs: “We’re closer to the end, hopefully, than the beginning.”

 

A Chronology of Major Challenges to Interchange And Other Policies

1996: Wal-Mart Stores Inc. files a class-action lawsuit challenging Visa’s and MasterCard’s so-called honor-all-cards rules, which required merchants accepting Visa- or MasterCard-branded cards to accept all cards, including debit. In a 2003 settlement, Visa settled for $2 billion and MasterCard for $1 billion. The settlement also required the networks to cut debit fees for a five-month period beginning in August 2003.

2005: Merchants filed 55 lawsuits against Visa and MasterCard claiming interchange fees were anti-competitive and violated antitrust laws. The merchants also challenged the legality of certain network rules that prohibit them from surcharging for card transactions or limit their steering of customers to the merchants’ preferred form of payment. Merchants involved in all but 10 of the lawsuits are seeking class-action status. The suit is set for trial in September.

2010: In October, the U.S. Department of Justice and the attorneys general from seven states (Connecticut, Iowa, Maryland, Michigan, Missouri, Ohio, and Texas) filed suit against Visa, MasterCard, and American Express alleging anti-competitive practices prohibiting merchants from steering customers toward cheaper forms of payment, including discounts, rewards, and information about card costs. In a settlement with the DoJ in October 2010, MasterCard and Visa agreed to allow merchants to offer an immediate discount or rebate or a free or discounted product or service for using a particular credit card network, low-cost card within a network, or other form of payment. Merchants also could express a preference for the use of a particular credit card network, low-cost card within a network, or other payment. AmEx is contesting the suit.

2010 and 2011: The Durbin Amendment in 2010 ordered the Fed to set “reasonable and proportional” debit card interchange price controls for issuers with more than $10 billion in assets. The Fed in June 2011 issued final regulations setting a price cap of 21 cents plus 0.05% and another 1 cent pending for fraud control. That represented a 47% cut on the average debit sale. The cap took effect Oct. 1.